Three scenarios for the budget battle between Republicans and the White House

The US debt-ceiling standoff could start a recession but a default would be worse, say economists.

Speaker of the US House Kevin McCarthy talks to reporters at the Capitol on May 17. Mr McCarthy and other Republican members of congress from the Senate and House are at an impasse with the White House over raising the nation's debt limit. Picture: Getty Images via AFP

Prolonged debt-ceiling squabbling could push the US economy into recession, while a government default on its obligations might touch off a severe financial crisis.

US lawmakers are negotiating over raising the federal government’s borrowing limit and may have just days to act before the standoff reverberates through the economy.

Treasury Secretary Janet Yellen said that the government could become unable to pay bills on time by June 1. In that case, the Treasury Department could halt payments, such as to federal employees or veterans.

In a worst-case scenario, a failure to pay holders of US government debt, a linchpin of the global financial system, could trigger severe recession and send stock prices plummeting and borrowing costs soaring.

Many economists don’t expect a default for the first time in US history. But they outline three potential ways the standoff could affect the economy and financial system, ranging from not great to extremely scary.

Scenario 1: Last-minute deal

The economy is already slowing due to rising interest rates, with many forecasters expecting a recession this year. While lawmakers haggle, uncertainty could cause consumers, investors and businesses to retrench, increasing the chances of a recession, said Joel Prakken, chief US economist at S&P Global Market Intelligence.

Workers aren’t likely to lose their jobs, but the unpredictability of the economic outlook could cause them to put off purchases.

Stock prices could start to decline as June 1 nears. In 2011, when congress raised the debt ceiling just hours before a deadline, stocks fell and took months to recover, Mr Prakken said. In the aftermath, the nation’s credit rating was downgraded.

“Even if we get an agreement before we run out of resources there still could be a legacy effect of the uncertainty that restrains economic growth,” Mr Prakken said.

S&P Global Market Intelligence projected in March that financial turmoil similar to 2011 could slow growth in U.S. gross domestic product to 0.1 per cent in the fourth quarter of this year from a year earlier, from an estimated 0.6 per cent gain otherwise.

Scenario 2: Deal after deadline

If negotiations extend beyond Thursday, June 1, economists expect a more severe reaction from financial markets, as the possibility for default looks more real.

“The shock would tend to accelerate quite rapidly” on June 1, said Gregory Daco, chief economist at Ernst & Young.

If consumers’ retirement and investment accounts suddenly shrink, they could sharply curtail their spending, the lifeblood of the US economy. Businesses could pause hiring and investment plans.

There is a possible window between June 1 and any missed payments. Yellen wrote that the actual date Treasury exhausts its cash could be days or weeks later than estimated. The Bipartisan Policy Centre projects Treasury to spend $US622.5 billion ($936bn) in June while taking in $US495bn in tax revenue. The exact timing of those inflows and outflows impact cash reserves.

Another possibility is that for a short time, the government gives priority to debt payments over others, such as Social Security benefits. Economists at UBS say that would have a notable, but less-severe, economic impact than a debt default.

They estimate under that scenario GDP would contract at a 2 per cent annual rate in the third quarter, and shrink further in the fourth quarter. Employers would shed 250,000 jobs in the second half of the year.

The silver lining of an economic downturn: Inflation would likely come down, as the US Federal Reserve wants. The central bank could also cut interest rates to help offset some of the economic weakness.

Scenario 3: No deal

If no deal is reached and the government can’t pay all its bills for days or weeks, repercussions would be enormous.

“There would be chaos in the global financial system because Treasurys [paper] are so important,” said Wendy Edelberg, an economist at the Brookings Institution. “What happens when that thing that everybody is benchmarking themselves to proves to be one of the riskiest things out there?”

Ernst & Young’s Daco said a default would trigger a recession more severe than the 2007-09 downturn.

The value of Treasurys would fall, as investors sell off and possibly permanently reduce their holdings. Missed payments would disrupt multitrillion-dollar global flows in short-term dollar borrowing, which are critical to how banks and companies fund operations.

Investment funds, companies and banks all hold Treasurys. Their falling value would hammer balance sheets. Recent bank runs were sparked by falling values of Treasury debt, and the declines could be much steeper in a default.

Analysts also say many investors would flee from risky assets of all sorts. The stock market would plummet 45 per cent in the following months, and unemployment would shoot up by 5 percentage points, a White House report said. UBS said a month-long impasse would cause the economy to contract for four-straight quarters.

Treasury yields influence interest rates across the economy, so consumers could see rates jump for credit-card debt, mortgages and auto loans.

Unlike in the 2020 Covid-19 recession — when the economy shed more than 20 million jobs but the government pumped trillions of dollars of stimulus — Washington would be unable to offer support, the White House report said.

The Wall Street Journal